Wednesday 22 April 2009

When is a target not a target?

The Reserve Bank of Australia (RBA) has an official inflation target band of 2%-3% "over the economic cycle". Apart from the difficulty of determining exactly what time period defines an "economic cycle", the target also seems to only affect RBA behaviour when it's broken on the upside. When inflation had spiked above 3% due to the oil and commodity price bubble, the RBA was intent on preventing inflation getting out of hand, raising interest rates in 2007 even when the US sub-prime crises was apparent.

At the moment inflation in Australia as just dropped back within the "target band" - dropping to an annual rate of 2.8% with the release of the latest 0.1% rise in CPI for the March 2009 quarter. This was lower than expected (0.5% was the consensus), and follows on from a -0.3% decline in the previous quarter.

With the past two quarters producing a drop in CPI of -0.2%, and the global economy not yet showing much sign of recovery, I can't imagine the next two quarters will show CPI increases of more than 0.5% each. That would see annual inflation drop to below 1% by the end of 2009 - well below the RBA target.

And yet despite the definite prospect of inflation dropping below 2%, the RBA seems more worried about cutting interest rates too far and creating excessive inflation pressures once the economy starts to recover. Indeed, the RBA only seems to show concern if there is a prospect of deflation. If that's the case, why not set the inflation "target" as 0%-3%, rather than having a target that isn't fair dinkum?

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